Is a home equity loan or line of credit right for me?

Home equity financing uses the equity in your home to secure a loan. For this reason, lenders typically offer better interest rates for this type of financing than they do for other, unsecured types of personal loans. Typically, you'll be able to borrow an amount equal to 80% of the value of your equity. Home equity financing may be either a loan or a line of credit.

A home equity loan (often referred to as a second mortgage) is a loan for a fixed amount of money that must be repaid over a fixed term. Generally, a home equity loan:

Advances the full amount you borrow at the beginning of the loan's term

Carries a fixed rate of interest

Requires equal monthly payments that repay the loan (including the interest) in full over the specified term

With a home equity line of credit (HELOC), you're approved for revolving credit up to a certain limit. Within the parameters of the loan agreement, you borrow (and pay for) only what you need, only when you need it. Generally, a HELOC:

Allows you to write a check or use a credit card against the available balance during a fixed time period known as the borrowing period

Carries a variable interest rate based on a publicly available economic index plus the lender's margin

Requires monthly payments that may vary in amount, based on changes in your outstanding balance and/or the prevailing interest rate

You may be able to deduct the interest you pay on up to $100,000 ($50,000 if married filing separately) of the principal you borrow under certain home equity financing plans. The interest you pay is generally deductible regardless of how you use the loan or line of credit proceeds (unless you use the proceeds to purchase tax-exempt vehicles). In other words, the loan or line of credit doesn't have to be obtained to buy, build, or improve your residence.

The best type of loan for you will depend on your individual circumstances. Generally, if you'll need a fixed amount of money all at once for a certain purpose (e.g., remodeling the kitchen or paying off other high-interest debts), you might want to take out a home equity loan. If you'll need an indeterminate amount over a few years (e.g., funds for college or a cash reserve account), you might want to obtain a HELOC. Keep in mind that you must examine your options carefully, since both of these loans are secured by your home.

Some HELOCs may cap the monthly payment amount that you are required to make, but not the interest adjustment. With these plans, it's important to note that payment caps can result in negative amortization during periods of rising interest rates. If your monthly payment would be less than the interest accrued that month, the unpaid interest would be added to you principal and your outstanding balance would actually increase, even though you continued to make your required monthly payments.